Reset Chart from Credit Suisse has a Major Error

Versions of the Credit Suisse reset graph have been featured in the Financial Times, used by the International Monetary Fund, and are a staple of web sites like these that are dedicated to the housing bubble. It’s fairly shocking then to see what appears to be a major error in their calculations.

Last week (here and here) I noted that something didn’t make sense about Wells Fargo’s estimates that only one third of one percent of their Option-ARM loans would recast before 2012. Reader’s comments and an email from CalcualtedRisk helped me to get my head around what was going on. In fact, Wells Fargo’s numbers are technically correct.

First for some background, when Wells Fargo purchased Wachovia it acquired about $120 billion of Option-ARM loans originated by a Northern California company called Golden West. These Option-ARMs, or “Pick-A-Payment” loans, allowed borrowers to literally pick their monthly payment from four options: 1) a payment that would pay off the loan in 15 years, 2) a payment that would pay off the loan in 30 years, 3) a payment that only covered the interest, and 4) a minimum payment that was less than the interest only payment.

The last option allowed for “deferred interest” or “negative amortization”. In essence, since not all the interest due was being paid by the borrower, the principal balance on the loan would grow each month. This was an extremely popular choice for borrowers at the peak of the real estate bubble, as Golden West noted in their 2005 year-end filing with the SEC:

In 2005, the initial monthly payment selected on almost all new loans was lower than the amount of interest due on the loans.

For obvious reasons this has been of particular concern. If the amount one owes on a loan goes up while the value of the home is decreasing, there is a heightened risk the borrower might walk away from the home leaving the bank to deal with the loss.

As the housing market has continued to deteriorate, the question on everyone’s mind is when will borrowers have to face the reality that they can't make a minimum payment forever? The Credit Suisse chart has been a guidepost for that reality check.

But interest rate resets don't pose much a problem for those with Option-ARMs when rates are low. They can continue making a minimum payment that only adjusts upwards by 7.5% once a year. The real "payment shock" comes when the loan is recast (i.e. becomes fully amortizing over the remaining term of the loan). This occurs after a contractual time limit (normally 5 or 10 years) or, if due to negative amortization, the loan value increases to 110-125% of the original principal of the loan.

For this reason Credit Suisse used the recast date in their chart above for Option-ARMs as stated by Mathew Padilla of the Orange County Register:

Credit Suisse, an analyst told me, used resets in the chart for all loans except option adjustable-rate mortgages, when borrowers can choose a minimum payment that may be less than interest owed (option ARMs are in yellow on the chart… see how they are rising!). For option ARMs it used recasts, which can happen either when the loan amount expands to a maximum allowed — often 115% or 125% of original principal — or a set period, such as five years.

If you’re paying close attention you'll notice that something doesn't add up. Wells Fargo, who holds more Option-ARMs on its books than any other institution, states in their last 10-Q filing:

Based on assumptions of a flat rate environment, if all eligible customers elect the minimum payment option 100% of the time and no balances prepay, we would expect the following balance of loans to recast based on reaching the principal cap: $4 million in the remaining three quarters of 2009, $9 million in 2010, $11 million in 2011 and $32 million in 2012... In addition, we would expect the following balance of ARM loans having a payment change based on the contractual terms of the loan to recast: $20 million in the remaining three quarters of 2009, $51 million in 2010, $70 million in 2011 and $128 million in 2012.

In short, Wells expects $56 million in Option ARMs to recast due to the loan balance reaching 125% of the value of the original loan and another $269 million to recast based on the terms of the loan. Given that we’re talking about a portfolio of over $100 BILLION of these loans, this means ESSENTIALLY NO LOANS WILL RECAST due to the negative amortization limits or contractual terms before 2012.

Both assumptions seemed suspect, yet, they are in fact true. Looking at page 55 of the Golden West 10-K from 2005 we read:

...most of our loans are scheduled to have a payment change without respect to any annual limit in order to reamortize the loan over its remaining life at the end of the tenth year or when the loan balance reaches 125% of the original amount. We term this reamortization a “recast.” Historically, most loans in our portfolio have paid off before the loan’s payment is recast.

History doesn’t look like it will be a good guide going forward but this at least clearly spells out what we are facing. If recasts don’t happen contractually for 10 years this means that the $49 billion of Golden West Option ARMs originated in 2004 will recast in 2014, and the $51 billion originated in 2005 will recast in 2015.

But take a look at the chart. Credit Suisse shows NOT A SINGLE OPTION-ARM RECAST IN 2014 (nor any in 2013 or the first three months of 2015).

Maybe Credit Suisse moved the recasts up based on the loans hitting their 125% balance caps as they state in their footnote? But again, the numbers don’t add up to what Wells states in their last 10-Q: virtually no recasts due to "reaching the principal cap" before 2012.


They also don’t add up if you model this out in excel with some actual numbers. Take a look at the table to the right (click for larger image):

Here we look at a hypothetical $500,000 Option-ARM mortgage originated by Golden West in January 2004 that now sits on Wells Fargo’s books. In order for the loan to recast before 2014 it needs to have enough negative amortization to hit the 125% limit. Wells Fargo assumes a "flat rate" environment in their calculations, but I assumed that today the CODI index (used for a majority of Golden West loans) plus margin jumps to 7% from its current level of 4.875%. At the end of the year I assume it jumps another 100 basis points to 8% and stays there until 2014.

Even with the assumption of higher rates the loan never hits its 125% cap. The loan currently has accrued about $40,000 of negative amortization. By 2014 it would accrue another $45,000, making the final balance $585,388 (115% of the original loan). In order to get the loan to hit the 125% cap by 2012 the accrual rate would need to jump today to 10% and say there for the next 3 years.*

In short, the Credit Suisse chart above looks to be incorrect. Contractually, these recasts won’t happen until 2014 and given the generous 125% cap it is unlikely negative amortization makes these loans hit that limit unless we have a major spike in interest rates. As mind boggling as it may seem, recasts for Wells Fargo’s giant Option-ARM portfolio won’t take place for another 5 years.

Of course, none of this is to say that Wells Fargo is out of the woods. They are essentially stashing away on their balance sheet tens of billions of neg-am loans that will recast into 20-year fixed rate mortgages in 2014 and 2015. Talk about a payment shock. (Although, it is important to note that the minimum payment automatically increases by 7.5% a year. If rates were to stay low this could mean that borrowers would eventually start paying more than their interest only payment and paying down their loans. My guess though is that these automatic increases will get people walking away from their homes before the recast date. Who wants to pay $3000 a month on a home that's underwater? Any way you look at it, it’s a mess.)

Also worrisome is that we’ve heard from readers that WaMu/JP Morgan is notifying Option-ARM borrowers that they are extending their minimum payments out another 5 years. Are they pushing off recasts into 2014/15 as well?

The bottom line something doens't add up when Wells Fargo predicts virtually no Option-ARM recasts before 2012, while Credit Suisse predicts no recasts after 2012. While I would guess Wells Fargo is underestimating recasts assuming a flat rate environment, the bulk of recasts do look like they will be pushed out to 2014/2015. Surely, some of these recasts need to be reflected in the Credit Suisse chart. I’ll leave it to others what this means for the housing market, but what is clear is this needs more attention.

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* [To verify these numbers download this spreadsheet from CalcualtedRisk, update the index with the CODI series, and plug in your own home values.]

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Update: Regarding the 125% cap, to clarify, this was for loans with a LTV of less than 85% at origination. This represents the structure of "almost all" the Option-ARM loans according the the Golden West 10-K:

A 125% cap on the loan balance applies to loans with original loan-to-value ratios at or below 85%, which includes almost all of the loans we originate. Loans with original loan-to-values above 85% have a 110% cap.

Case-Shiller Bay Area Update with Futures Data

(Click Image for Larger View)
Above is our monthly chart updating the Case-Shiller numbers with futures data from the Chicago Mercantile Exchange.

While the CME futures continue to predict home price declines out through the end of the year, they are slightly above where they were last month.

Courthouse Steps Auction in Sonoma County

Dave Roberts has a first person account up of a recent foreclosure auction down at 575 Administration Drive. If you've never attended one of these it is well worth the read. Here is a snippet:

Finally, on the sixth try, we got an active auction going. The opening amount for this property was only $62,000 and a series of four bidders made their way to the auctioneer to demonstrate their financial bona fides and provide their names. I should mention the auction master made it clear that cash or cashier's check were the only legal tender for the auctions and that even though she might say "sold" to a high bidder, until the money was in her hands, the bidding was still open...

There would be a long pause, much talking on cell phones, wandering back and forth on the plaza and then the fateful words, "plus 100". This went on for about an hour at which time the winning bidder (pictured with the phone to his ear (also the main Mr. Plus 100)) got the right to pay $128,000 for the property. I think that was probably a good deal, but several bidders had stopped at around $115,000, so maybe the deal isn't as good as I thought.

Surge of Activity at the Healdsburg Commons

Over the last few months there has been quite a bit of activity at the Healdsburg Commons. Units have sold, others have gone into escrow, and units still on the market have had their prices slashed.


Above is an updated chart with data I've pulled off the web on the units. Two things to note: 1) It will be interesting to see the actually selling price of the units currently in escrow if in fact the sales go through and 2) what price cuts will be needed to clear the remaining six units.

More on Option-Arms and a Request to Readers

It turns out we were on to something in the last post and all the comments questioning Wells Fargo's assumptions on Option-ARMs.

Above is the latest version of the Credit Suisse mortgage reset chart. The Orange County Register states:

Note that the chart uses both resets, when interest rates change, and recasts, when payments change. Resets and recasts often happen at once, but not always. Credit Suisse, an analyst told me, used resets in the chart for all loans except option adjustable-rate mortgages, when borrowers can choose a minimum payment that may be less than interest owed (option ARMs are in yellow on the chart… see how they are rising!). For option ARMs it used recasts, which can happen either when the loan amount expands to a maximum allowed — often 115% or 125% of original principal — or a set period, such as five years.

Funny how Wells Fargo assumes virtually no recasts before 2012. Remember, Wells states that they expect only $325 million to recast before 2012 assuming flat rates. This on a portfolio of over $100 billion.

Is Credit Suisse taking this into account? Or are we going to get another wave in 2015? Either way Wells Fargo's assumptions are insane. CalculatedRisk asks the same questions and promises a follow up post.

Also, I have a request for readers. It has been mentioned in the comment section that banks have been automatically extending the teaser rate periods for up to 5 years on loans. One reader wrote saying the low rate on their Option-ARM from WaMu had been automatically extended for another 5 years last fall. There are some really perverse incentives here as A) the new low rate keeps people paying but just pushes the day of reckoning out and B) banks get to book this additional negative amortization as revenue (this has been called "phantom revenue" see more here).

Does anyone have access to a copy of one of these letters that is automatically extending low rates another 5 years? If so, I'd love to take a look at a copy and post it. You could black out all the names and account information to make it anonymous. If you could obtain something like this please send it to healdsburgbubble@gmail.com.

Remember, Sonoma County is ground-zero for Option-ARMs. These loans will no doubt be a driver for the high-end housing market for years to come.

Big Price Cut at 529 Fieldcrest Drive

After "selling" for $473,064 two weeks ago, 529 Fieldcrest Drive is back on the market and now listed for $332,500.

This should be of particular interest to comps in the area.

Something Not Adding Up on Option-ARMs

Here in Sonoma County we need to pay particular attention to Option-ARM loans (some of the most toxic that allowed for negative amortization). As we've pointed out before, we are second nationally only to Salinas in issuance of Option-ARM loans according to BusinessWeek. This a time bomb on the horizon for Sonoma County as 37.7% of all loans were financed this way in 2005 in our locality.

For this reason I pay close attention to any mention of these loans in the media. This morning I noticed CalculatedRisk linked to a New York Times article that has me scratching my head.

Well Fargo, thanks to its acquisition of Wachovia, has around $115 billion Option-ARMs (or as they call them "Pick-a-Payment") on its balance sheet. But according to the article:

Only $325 million of the [Wells Fargo Option-ARM] loans — less than a third of 1 percent — will reset by the end of 2012.

Say what? Something doesn't mesh with the chart that leads off this post. Notice that it shows virtually all of the Option ARMs resetting (recasting?) before 2012.

But yet it's true. Here are the actual numbers from Wells Fargo’s filing with the SEC:

Based on assumptions of a flat rate environment, if all eligible customers elect the minimum payment option 100% of the time and no balances prepay, we would expect the following balance of loans to recast based on reaching the principal cap: $4 million in the remaining three quarters of 2009, $9 million in 2010, $11 million in 2011 and $32 million in 2012. In first quarter 2009, the amount of loans recast based on reaching the principal cap was de minimus. In addition, we would expect the following balance of ARM loans having a payment change based on the contractual terms of the loan to recast: $20 million in the remaining three quarters of 2009, $51 million in 2010, $70 million in 2011 and $128 million in 2012. A payment change recast occurred on $4 million of loans during first quarter 2009.

In short, Wells expects $56 million in Option ARMs to recast due to the loan balance reaching 125% of the value of the home and another $269 million to recast based on the terms of the loan. Given that we’re talking about a portfolio of over $100 BILLION of these loans, the bulk of which are in California, Florida and Arizona, how can this be?

Surely more than a fraction of one percent of the homes behind these neg-am loans will not meet the 125% loan-to-value requirement, even in a flat rate environment (and I think that assumption is a stretch). The same goes for the contractual recast. My understanding was that this was structured to take place 60 months (5 years) from origination. So how can Wells say that only $269 million will recast by 2012?

Has Wells Fargo gone mad? Or am I missing something? Any input in the comment section would be greatly appreciated.

Of note: It’s important to understand the difference between "reset" (interest rate changes) and "recast" (payments change to reflect full amortization). CalculatedRisk has a great post on the subject.

UPDATE: Please take a look at the follow up post on this topic here.

More on the Coming Foreclosure Wave

From today's Press Democrat:

But a new wave of foreclosures is building. More county homeowners are falling behind on their mortgages, and some could lose homes to banks while others sell to avoid foreclosure. The latest data indicates 4.7 percent of mortgages in the county were 90 days or more late in March, up from 3.5 percent a year earlier, according to First American CoreLogic, a real estate research company.

Already, lenders have seized 2,970 homes in Sonoma County during the 12-month period through March, more than double from a year ago, First American CoreLogic reported.

A rising tide of foreclosed homes could wash over buyers if their numbers don’t grow to match the busiest years of the last home sales boom, Holmes said.

“If we have this much inventory and we’re not even keeping up with our peak year — even though prices are so much lower — it indicates we don’t have enough buyers,” she said.

New Foreclosure Wave Begins in California

It looks like May might be the first month that foreclosures begin to once again flood the market in California.

This report over at CNBC (via Patrick.net) states that foreclosures did not surge in April because "banks simply didn’t have the capacity to process all the distressed loans" due to the moratorium.

They quote Mark Hanson of the Field Check Group regarding Washinton Mutual loans:

Beginning on May 4th the properties taken to foreclosure in CA surged. For the past few months, WaMu had been on near full foreclosure moratorium. As of May 7th -- only 5 calendar days into the month -- WaMu already has 10% MORE foreclosure-related REO’s than in all of April. At this run rate, WaMu will have a record foreclosure month of 3300 foreclosures in CA alone or 7000 nationally worth approximately $2.5 billion.

This fits right in to the data we've presented on Sonoma County:

60% of Sonoma County Homes Sold in the Last 5 Year Have Negative Equity

Zillow.com just released data for the first three months of 2009 showing that nationwide 20% of homeowners owe more on their mortgage than their house is worth.

While those numbers sound horrific, they are nothing compared to what has happened in Sonoma County over the last 5 years.

Taking a look at the Zillow data for the Santa Rosa-Petaluma MSA, we find that 59.6% of mortgages for homes purchased from 2004-2009 have negative equity. Let that sink in... SIXTY PERCENT.

It that is not enough, for homes sold in 2005 and 2006 more than 70% are worth less than the debt owed on the home. Again, let that sink in... SEVENTY PERCENT.

Unless homes drastically begin increasing in value in short order (which they won't), many of these people will simply walk away these mortgages. It's little wonder the banks are in the mess they find themselves.

Finally, here is a map from Zillow showing negative equity for our area:

Renting vs. Buying

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